While we all know that employers are required to withhold taxes from employees’ pay, it’s been unclear in California how that applies to settlements. Must the employer withhold taxes from payments for lost income (back pay or front pay)? Or can it pay the settlement proceeds without withholding and have the plaintiff take responsibility for tax payments?
A 1992 state court of appeals opinion, Lisec v. United Airlines, said that an employer isn’t required to withhold taxes from a payment to a former employee. But many federal cases and IRS interpretations since then have reached the opposite conclusion. Then, on June 26, 2015, a different state court of appeal joined that chorus in saying that payments to departed employees for lost income were subject to withholding. While that case, Cifuentes v. Costco Wholesale, dealt with payment of a judgment, the court said that the same rules applies whether the case is resolved by litigation or settlement.
Going forward, employers who settle employment claims should designate a portion of the settlement as lost wages and withhold taxes from that portion. Will this make cases harder to settle? Yes. It’s another issue to haggle over and it results in settling plaintiffs seeing less money in their pockets in the short term. But many employers have been doing this for years and they still manage to settle cases. Also, employers who fail to withhold taxes can be liable for penalties and taxes or even jailed! So if you pride yourself on giving employers advice that doesn’t get their managers sent to prison, it’s time to start withholding taxes from lost income settlements.